Market research firm Kaiko has published a study on Ethereum’s flagship protocol, Lido Finance (LDO). the Stady A must read for every ETH and LDO investor!
Cautionary tales are valuable reminders of the risks and pitfalls that can await even the most promising of projects. Remarkably, Lido Finance has embarked on a massive growth trajectory in recent months, reminiscent of the former crypto industry poster child Three Arrows Capital (3AC). Riaz Kari, Analyst at Kaiko wrote:
Essentially, 3AC bet that GBTC — an asset very different from BTC, with significant entry and exit frictions — would closely track the price of BTC. This saga was at the forefront of mind as I noticed stETH (and other liquid storage derivatives) starting to replace ETH in DeFi protocols.
Search results by Kaiko
Kaiko’s in-depth research provides important insights into Lido’s operations and the potential risks it faces. According to Kaiko’s analysis, “Lido’s success story raises concerns about potential vulnerabilities and risks lurking beneath the surface.” By examining a wealth of data, Kaiko highlights liquidity challenges, leverage risks, and the potential for a major liquidation event.
Lido Finance is a platform that allows users to participate in Ethereum and receive stETH tokens, which represent the value of the initial deposit and staking rewards. Kaiko’s research reveals the staggering growth of stETH tokens over the past year and a half, with the supply increasing fivefold from 1.5 million to 7.5 million, and the number of holders rising from 40,000 to nearly 220,000.
The analysis by Kaiko also highlights the importance of liquidity in the context of staking derivatives such as stETH. One crucial aspect confirmed by the research is Lido DAO’s reliance on Curve’s stETH-ETH pool to provide liquidity.
Caico data shows that since June 2023, the liquidity incentives for this pool have been fading away. As a result, liquidity decreased, and a clear downward trend emerged. This change in incentives raises concerns about the stability of the stETH-ETH pool during periods of stress or market events, which could lead to a liquidity crisis.
Another important aspect that Kaiko’s research has discovered is the increased leverage associated with the use of stETH. The analysis indicates that lending and borrowing protocols are becoming hubs for leverage, with stETH gaining popularity as an asset to leverage strategies.
However, the research highlights the fundamental differences between StETH and ETH, along with deteriorating on-chain liquidity, which raises concerns about the risks associated with these leveraged positions.
Kaiko found that about one month after stETH was added to Aave V2, it became the most deposited asset, while ETH loans rose from less than $200 million to $1.6 billion in just two months. The cause is alarming, according to the research company:
This is due in large part to the popularity of leveraging stETH manually: depositing stETH into Aave, borrowing ETH, swapping or storing it for stETH, and repeating it as many times as is convenient. This is a process that is beginning to look disturbingly similar to 3AC’s GBTC trading, as the founders assumed that GBTC would trade closely with BTC.
Implications for the future of Ethereum and Lido
Based on the research, the combination of deteriorating liquidity and increasing leverage presents a risky situation as the potential for a significant liquidation increases. Kaiko says:
Again, this is not a flaw in StETH but rather in how it is used. In fact, any major liquidation event that increases the stETH discount could present a fantastic opportunity for anyone brave enough to catch the drop.
Data from Kaiko’s analysis reveals the withdrawal of liquidity from the stETH-ETH pool and underscores the potential risks arising from insufficient on-chain and off-chain liquidity.
This lack of liquidity could hinder the liquidation of large STETH positions, which could burden lending and borrowing protocols with large bad debts.
Kaiko’s results underscore the importance of vigilant risk management and proactive measures to address liquidity concerns in order to protect Lido’s future stability. To conclude, the company has advice for the Lido DAO:
The DAO is understandably tired of offering such large incentives in the Curve pool, but with those incentives removed (for now), the DAO should seriously consider paying a market maker to provide liquidity on a variety of centralized and decentralized exchanges.
At the time of writing, the LDO price is down 10% in the past 24 hours and is trading at $1.90. The outlook for LDO currently looks very bearish as long as the price continues to move in the downtrend channel that was established in early March.
Featured image from iStock, chart from TradingView.com